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Intesa Sanpaolo SpA
Pirelli & C. SpA
Yields on Italian government bonds reached frightening heights on Nov. 9, the day after Silvio Berlusconi, Italy’s longest-serving Prime Minister, offered to resign as soon as Parliament passes an austerity package. The market’s refusal to be appeased by Berlusconi’s promised departure indicates that even more dramatic measures may be required to prevent a death spiral for Italy’s $2.6 trillion in sovereign debt. “Bond spreads don’t allow us to wait, not even one hour,” Dario Franceschini, leader of the opposition Democratic Party, wrote in a posting on his website.
The increasingly dire situation in Italy—whose sovereign debt is the fourth-largest in the world—sent shock waves across the euro zone and beyond. “Tragically in Italy … the price of borrowing money is getting to a totally unsustainable level,” British Prime Minister David Cameron told lawmakers in London on Nov. 9.
Italy faces long-term slow growth as well as short-term investor panic in the bond market. Although both must be solved, the country’s deteriorating government finances are clearly the more immediate threat. The yield on 10-year bonds jumped on Nov. 9 to 7.2 percent, above the threshold of 7 percent that led Ireland, Portugal, and Greece to seek bailouts. Worse, yields on short-term securities passed 7 percent, too, a sign of fear that Italy will default.
Any cheer from Berlusconi’s promised—and long overdue—exit was dampened by news on Nov. 9 that LCH.Clearnet, a London-based clearing house, was raising the deposit it demands for processing the trades of Italian securities. The deposit protects LCH in case a deal fails and it gets stuck holding Italian bonds. For Italy, the LCH change “highlights the deterioration of its credit quality,” says Eric Wand, a fixed-income strategist at Lloyds Bank (LLOY) Corporate Markets in London.
Even before the latest rout, economists at Barclays Capital (BCS) warned on Nov. 7 that Italy may have passed the point of no return. When bond yields get high enough, they go from enticing to alarming—investors worry that the government won’t be able to afford the payments and will eventually default. Barclays said only the European Central Bank has the firepower to halt the run on Italian debt by committing to buying as many Italian bonds as necessary. New ECB President Mario Draghi—eager to establish his anti-inflation bona fides—has said he won’t do so.
Berlusconi is known as il Cavaliere, or the Knight. With his ruling majority unraveling, he has said that passing a plan to reassure financial markets will be his final mission. Italy’s planned austerity measures, likely to include an accelerated sale of up to $83 billion in state assets, won’t solve the underlying problem, which is lack of growth. Over the past 15 years, Italy’s economy has expanded an average 0.9 percent annually, half the European Union average, according to Eurostat. The International Monetary Fund’s prediction for this year is only 0.6 percent.
Without growth, Italy can’t pay down its debt, which stands at 119 percent of gross domestic product, a figure that hasn’t changed much since the mid-1990s. “We’ve done a better job than others controlling our deficits, but not regarding growth,” Corrado Passera, chief executive officer of Italy’s No. 2 bank, Intesa Sanpaolo (ISP), said at a conference in Milan on Nov. 7. Italy’s budget deficit is only 4.6 percent of GDP, well below the euro zone average of 6 percent.
Italy could have avoided this mess. It’s a major exporter with a strong entrepreneurial culture and good companies such as oil group ENI (E) and tiremaker Pirelli (PPAMF)—as well as Fiat (FIADF), which has saved thousands of American jobs by pulling Chrysler back from the brink. And while Berlusconi’s bunga-bunga parties make great tabloid fodder, fiscal policy has been competently managed by Finance Minister Giulio Tremonti.
Still, productivity has been stifled by overregulation, rigid labor rules, and a government role in industries such as energy and media that have been privatized elsewhere. In 1991, Italian labor productivity was about 11 percent lower than the average for the top half of the industrialized countries. By 2009 it was almost 28 percent lower. “There are deep-rooted structural problems at every level,” says Fabio Fois, European economist at Barclays Capital.
The government has tried to juice the economy by investing in infrastructure and education—only to have benefits siphoned off by corruption, says Daniel Gros, director of the Center for European Policy Studies in Brussels. Italy’s state auditor says cases of corruption and bribery increased 30 percent last year. Berlusconi himself has been indicted in three corruption cases. He denies any wrongdoing.
The question now is how quickly Italy can get new leadership in place. Once Parliament passes an austerity plan and Berlusconi resigns, President Giorgio Napolitano will try to form a new government. He could appoint a so-called technical government, led by a prominent outsider such as former EU Commissioner for Competition Mario Monti, that would be charged with implementing reforms and eventually setting new elections. But Berlusconi has insisted that voters should choose the next government. In a Nov. 9 television interview, the Prime Minister said Angelino Alfano, head of his governing People of Liberty party, was in “pole position” to succeed him.
Whoever takes charge of the government will face a monumental task. As Mario Baldassarri, a former Berlusconi ally who chairs the Senate Finance Committee, asks: “Which government, with what wide majority, will be able to implement in a few days the structural reforms that we haven’t been able to implement in the last 10 years?”
The bottom line: Italy’s debt crisis shows signs of spinning out of control. The debt burden may be so heavy that austerity won’t work.